When it comes to variable annuities, many financial pros offer a few words of advice: Use with caution.
Indeed, as complex investments that are tricky to understand, variable annuities come with risks that sometimes can outweigh the expected rewards.
"The plain-vanilla ones aren't necessarily a bad deal if they're used the right way," said certified financial planner Colby Winslow, a senior wealth planner with WaterOak Advisors. "But sometimes the fees are so prohibitive that they don't justify using one."
Nevertheless, advisors say that in some cases a variable annuity ends up being the best option for a portion of an investors' retirement money.
In simple terms, these annuities are a type of investment that offers some income-stream guarantees in retirement. You give an insurance company your money, either in a chunk or through regular contributions, and choose from a menu of underlying funds to invest in. Those funds generally are invested in stocks, bonds or a mix of the two, which means the value of your investment will fluctuate with the performance of those funds.
Some variable annuities are immediate and you begin getting payments right after you purchase the annuity. Others are deferred, in which case at some future date you can annuitize — meaning you agree to receive a periodic amount (typically monthly) — for a set time period or for the rest of your life.
Additionally, any gains on your account are tax-deferred until you make withdrawals, at which point you'll pay ordinary tax rates on the income.
For some people the promise of an income guarantee can override the concern of higher costs. But even if you are one of those investors, advisors caution against putting more than a third or so of your retirement money in a variable annuity.
"If you put too much into it, you'll have a liquidity problem," said CFP Ed Vargo, founder of Burning River Advisory Group.
For starters, variable annuities operate under withdrawal rules similar to individual retirement accounts and 401(k) plans: In most cases a 10 percent federal tax penalty is slapped on withdrawals made before age 59½.
But even if you are beyond the age minimum, many variable annuities come with an initial surrender period. During this time — typically six to eight years — you'll pay a surrender charge if you withdraw more than a preset annual limit.
Those charges are typically steep, especially in the early years of owning the annuity. For example, an eight-year surrender period might come with an 8 percent surrender charge in the first year that gradually decreases before reaching 1 percent in its last year.
Generally speaking, surrender charges allow insurance companies to recoup the commission they paid the agent who sold you the annuity. Sometimes those commissions can reach 5 percent or more.
Some advisors earn a yearly fee to manage your annuity instead of a commission, and those arrangements are less likely to have a surrender period.
Some companies offer basic variable annuities with yearly fees that are more reasonable — say, 1.5 percent of assets managed — but investors often purchase additional benefits with their annuity.
For instance, a popular add-on is a guaranteed minimum income. This benefit assures a certain payment amount even if the value of your investment drops.
"The fees can be significant, but what are you getting for the fees?" Vargo said. "If the client is willing to pay, say, 2 percent more but is guaranteed to never outlive their money and it helps them sleep at night, it can make sense."
Regardless of why you might consider a variable annuity, advisors say it's important to understand the effect that fees have on your investment. If, say, your annuity grows by 7 percent in a year but your fees reach 4 percent, your bottom-line gain is just 3 percent.
Another consideration is the cost of living. Thanks to inflation, the amount you receive in year one upon annuitizing is worth far less in 10 or 20 years. For example, the purchasing power of $50,000 today would drop to under $39,000 after 10 years at a modest 2.5 percent yearly inflation rate.
There's also some debate over whether variable annuities should be used inside an IRA. Naysayers point to the fact that an IRA's earnings already are tax-deferred, so you get no additional tax-deferral benefit.
However, sometimes advisors get new clients whose entire retirement savings are in an IRA. And if clients have a fear of a market crash or of outliving their money, it can sometimes make sense to move existing IRA funds into a variable annuity.
"Most people don't get into these for the tax benefits," Vargo said. "They're going into one because they went through [the dot-com bubble] in 2000, they went through [the financial crisis] of 2008, and they don't want to see their portfolio drop.
"It just helps take some of that concern off a client's plate."
CFP Chris Chen said that some people who turn to variable annuities for security fear a complete market meltdown.
"A lot of people imagine the worst," said Chen, a wealth strategist with Insight Financial Strategists. "They're not afraid of the market dropping by 10 percent — they're afraid of it going to zero."
He said that if rock bottom were to occur, there's a good chance that insurance companies would struggle to honor their annuity contracts because their own value is tied to the market's performance.
"The risk [in the market] is not as high as some people make it out to be, but if it is, then an annuity from an insurance company might not be the right refuge from that," Chen said.
Much of knowing whether a variable annuity is a good option depends on all sorts of related financial considerations, including other sources of income in retirement and your individual situation and goals.
"You should do a financial plan that includes other factors you should consider and put the annuity in that [context]," Chen said. "In some cases it might be fine, but in other cases it won't be."
— By Sarah O'Brien, special to CNBC.com